Don't Be Fooled By High P/Es

After ten years at the right hand of investing legend Bill Miller, Lisa Rapuano surprised many by leaving
Legg Mason
last year to join Matador Capital Management. "Now I devote most of my time to managing portfolios and picking stocks, which is what I love," says Rapuano. "I was doing less of that as Legg got so big."

While Miller's head of research, Rapuano also co-managed and then managed Legg Mason's
Special Investment Trust from 1999 through 2003, trouncing the S&P 500, returning 14.5% per year versus an annual loss of 0.7% in the index.

In this excerpt from a recent interview with Value Investor Insight newsletter (exclusively available at Forbes.com), Rapuano describes the three "layers" of the best investments, and why she sees tremendous value in videogame maker
Activision
.

Value Investor Insight: Describe the investment opportunities that are most likely to interest you.

Lisa Rapuano: The ideal opportunity is where you have a variant long-term perception, a really big discount to your discounted cash-flow value, lots of free cash flow, increasing returns on capital, it's five times EBITDA (earnings before interest, taxes, depreciation and amortization) and it's nine times earnings. But that never happens.

We're looking for things that are undervalued, where we understand why they're undervalued and believe the reasons are temporary or just wrong. All businesses have an intrinsic value. The market is reasonably efficient in the long term in arriving at that intrinsic value; but in the short term, there are lots of reasons why share prices deviate from that value.

I think about it this way: Perfect investments have three layers of return. The first layer is the short-term return to what I'd call static intrinsic value. The second one is when the business, strategy and management turn out to be what you think they are, and there's real value creation. The third layer, if you're really lucky, is when the market gets so excited that it discounts more and more of the future into the present. The big homeruns are usually there.

You said your stocks don't always appear cheap, which brings us to Activision.

LR: This is one of the companies where we've gone through the first layer of value, but where I know there are layers beyond this. The question is how much risk I'm willing to take to get there, which I think right now is at a reasonable level.

I love the videogame business. It's a high-margin, high free-cash-flow business with remarkable installed-base growth. There's a gigantic secular tailwind behind this business, which I think is unstoppable. We're in the midst of a massive change in the world of media, broadly defined, and videogames will continue to take time away from old media. People who are of the proper investment age don't get it, so it's unlikely for this change to be fully discounted in share prices.

A couple other things tend also to weigh on videogame stocks. They've traditionally been held back in "console-transition" years like we're currently in. That's because someone always blows up because they get caught with too much inventory for one machine and too little for another. But now you have three game platforms, and they come out at different times. Backward compatibility is getting better, and the game companies, in general, have learned better how to execute.

Investors who consider themselves forensic accounting people don't like how the companies in the industry all account for things differently.
Electronic Arts
expenses product-development costs, while Activision capitalizes them, for example. There's a lot of judgment in the accounting, but it's all perfectly understandable if you spend some time on it.

So what makes Activision particularly interesting?

LR: This is a rich man, poor man industry. Right now, Electronic Arts is the only true rich man. They've broken the code. We think there's a reasonable bet that Activision can do the same.

The positive economics accelerate in this business for the winners. With Activision, they've been so stellar on execution and developing great games that operating margins have gone from 8% to 11%, to what we think will be 13% this fiscal year. The company will tell you they can do 25% and explain in detail how they're going to do that. If they do, the stock, now at $20, goes to $40.

I'm not counting on 25% margins, but I think the stock is worth easily in the high $20s or even low $30s just from steadily increasing margins. The multiple has gone up, but only to a more normal range--about 20 times fiscal 2006 free-cash flow after backing out $4.50 per share in cash.

Aren't you betting on their ability to keep cranking out hits, which is risky in a creative business like this?

LR: So there's the issue--almost like with money management--can you have a platform and process that generates superior returns year after year? Electronic Arts has so far, but no one else has. So we have to be assessing the probability that Activision can institutionalize that, and so far there's zero evidence that they can't. Bobby Kotick, the CEO, has built this company up from nothing. He hasn't always had the greatest reputation with shareholders, which I think is unfortunate, because this is a very well-run company. Kotick's shareholder letters are among the best I've ever read.

It cracks me up that nobody liked Activision at $13 and now at $20 people are upgrading after they blew their numbers out for the fourth quarter in a row. My perception is now more conventional, which increases my risk, but I don't want that to make me jump off the train when it's going along as well as I think it will.

This excerpt is from an original interview published in the Sept. 28, 2005 issue of Value Investor Insight newsletter. For more information on Value Investor Insight, including this entire interview with Lisa Rapuano, click here.